PhD, SMIEEE
Text: Ballou Business Logistics Management, 5/E (Chapter 9-10)
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To understand some basic concepts of inventory
To anticipate typical problems involved in supply scheduling decisions
To understand some basic concepts of purchasing
Dickson Chiu 2006 Inventory-2

Business Logistics Management, 5/E (Chapter 9)
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Finished product held for sale
Goods in warehouses
Work in process
Goods in transit
Staff hired to meet service needs
Any owned or financially controlled raw material, work in process, and/or finished good or service held in anticipation of a sale but not yet sold
Dickson Chiu 2006 Inventory-4

Material sources
Inbound transportation
Production Outbound transportation
Finished goods warehousing
Customers
Production materials
Inventories in-process
Finished goodsS
Inventory locations
Dickson Chiu 2006 Inventory-5

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Improve customer service
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Provides immediacy in product availability
Encourage production, purchase, and transportation economies
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Allows for long production runs
Takes advantage of price-quantity discounts
Allows for transport economies from larger shipment sizes
Act as a hedge against price changes
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Allows purchasing to take place under most favorable price terms
Protect against uncertainties in demand and lead times
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Provides a measure of safety to keep operations running when demand levels and lead times cannot be known for sure
Act as a hedge against contingencies
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Buffers against such events as strikes, fires, and disruptions in supply
Dickson Chiu 2006 Inventory-6

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They consume capital resources that might be put to better use elsewhere in the firm
They too often mask quality problems that would more immediately be solved without their presence
They divert management’s attention away from careful planning and control of the supply and distribution channels by promoting an insular attitude about channel management
Dickson Chiu 2006 Inventory-7

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Pipeline
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Inventories in transit
Speculative
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Goods purchased in anticipation of price increases
Regular/Cyclical/Seasonal
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Inventories held to meet normal operating needs
Safety
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Extra stocks held in anticipation of demand and lead time uncertainties
Obsolete/Dead Stock
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Inventories that are of little or no value due to being out of date, spoiled, damaged, etc.
Dickson Chiu 2006 Inventory-8

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Perpetual demand
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Continues well into the foreseeable future
Seasonal demand
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Varies with regular peaks and valleys throughout the year
Lumpy demand
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Highly variable (3   Mean)
Regular demand
Accurately forecasting demand is singly the most important factor
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Not highly variable (3  < Mean)
Terminating demand
 in good inventory
Demand goes to 0 in foreseeable future management
Derived demand
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Demand is determined from the demand of another item of which it is a part
Dickson Chiu 2006 Inventory-9

PUSH - Allocate supply to each warehouse based on the forecast for each warehouse
PULL - Replenish inventory with order sizes based on specific needs of each warehouse
Demand forecast
Warehouse #1
Q
1
Plant
A
1
A
3
A
2
Q
2
Warehouse #2
Q
3
A = Allocation quantity to each warehouse
Q = Requested replenishment quantity by each warehouse
Warehouse #3
Dickson Chiu 2006
Demand forecast
Demand forecast
Inventory-10

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Pull
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Draws inventory into the stocking location
Each stocking location is considered independent
Maximizes local control of inventories
Push
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Allocates production to stocking locations based on overall demand
Encourages economies of scale in production
Just-in-time
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Attempts to synchronize stock flows so as to just meet demand as it occurs
Minimizes the need for inventory
Supply-Driven
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Supply quantities and timing are unknown
All supply must be accepted and processed
Inventories are controlled through demand
Aggregate Control Classification of items
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Groups items according to their sales level based on the 80-20 principle
Allows different control policies for 3 or more broad product groups
Dickson Chiu 2006 Inventory-11

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Carrying costs
Procurement costs
Out-of-stock costs
Dickson Chiu 2006 Inventory-12

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Price of the goods
Cost of preparing the order
Cost of order transmission
Cost of production setup if appropriate
Cost of materials handling or processing at the receiving dock
Dickson Chiu 2006 Inventory-13

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Cost for holding the inventory over time
The primary cost is the cost of money tied up in inventory, but also includes obsolescence, insurance, personal property taxes, and storage costs
Typically, costs range from the cost of short term capital to about 40%/year. The average is about 25%/year of the item value in inventory.
Dickson Chiu 2006 Inventory-14

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Lost sales cost
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Profit immediately foregone
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Future profits foregone through loss of goodwill
Backorder cost
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Costs of extra order handling
Additional transportation and handling costs
Possibly additional setup costs
Dickson Chiu 2006 Inventory-15

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Good inventory management is a careful balancing act between stock availability and the cost of holding inventory.
Service objectives
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Setting stocking levels so that there is only a specified probability of running out of stock
Cost objectives
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Balancing conflicting costs to find the most economical replenishment quantities and timing
Customer Service , i.e., Stock Availability
Inventory Holding costs
Dickson Chiu 2006 Inventory-16

Total cost
Minimum cost reorder quantity
Replenishment quantity
Dickson Chiu 2006
Procurement cost
Stockout cost
Inventory-17

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Make a one-time purchase of an item. How much to order?
Balance incremental profit against incremental loss .
Estimated these expected values …
Dickson Chiu 2006 Inventory-18

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Develop a simple control system by finding the replenishment quantity ( Q ) and the reorder point ( ROP ).
Applicability: no uncertainty in demand or lead time: manage regular (cycle) stock only
Quantity on-hand plus on-order
Q
Reorder point, R
0
Order
Placed
Lead time
Order Order
Received Placed
Dickson Chiu 2006
Lead time
Order
Received
Time
Inventory-19

ROP
0
Place order
Q
Receive order
Stockout
LT
Time
Dickson Chiu 2006
LT
Q
Inventory-20
Demand
During
LT
P

ROP
Quantity for control
Quantity on hand
+on order
 backorders
Actual on hand
Q
0
LT
Safety stock
Time
Dickson Chiu 2006
LT
Inventory-21

Finding the reorder point requires an understanding of the demand-during-lead-time distribution
P
DDLT
Week 1 Week 2 Week 3
+ + s d
=10 s d
=10 s d
=10 d =100 d =100 d =100
Weekly demand is normally distributed with a mean of d = 100 and a standard deviation of s d
= 10
Lead time is 3 weeks
Dickson Chiu 2006
=
S
’
=17.3
z
X = 300 ROP
X
 d

LT

100(3)

300 s
'  s d
LT

10 3

17.3
Inventory-22

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Non-instantaneous re-supply At times, production or supply continues while demand is depleting inventories.
Reorder point control with demand and lead time uncertainties
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The combined effect of these two uncertainties is particularly hard to estimate accurately.
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It is the standard deviation of the demand-during-lead-time distribution that is the problem, especially if the level of demand and the length of the lead time are related to each other.
Ideally, we would simply observe the actual demand occurring over each lead time period.
If the demand and lead time are independent of each other and each are represented by separate distributions, we may estimate the standard deviation ( s ′) from s '

LT ( s 2 d
)
 d 2 ( s 2
LT
)
Dickson Chiu 2006 Inventory-23

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The inventory is reviewed at the time interval (
) to determine the quantity on hand. The replenishment quantity ( ordered is the difference between a target level called
) to be and the quantity on hand.
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Good method for products:
Of low value
That are purchased from the same vendor
Having economies of scale in production, purchasing, and transportation
Dickson Chiu 2006 Inventory-24

M
Q
2
Q
1 q
Stock level reviewed
0
M = maximum level
M q = replenishment quantity
LT = lead time
LT
T
Order received
Dickson Chiu 2006
LT
T
Time
T = review interval q = quantity on hand
Q i
= order quantity
Inventory-25

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Perpetual inventory control for most firms is the problem of managing items jointly rather than singly.
This occurs since more than one item is typically purchased from the same vendor.
The approach to joint ordering is to find a common order review interval ( target levels ( service levels.
MAX
T ) and then to set separate
) based on specific item costs and
A common review time may be specified, or it may be computed based on appropriate economics.
Dickson Chiu 2006 Inventory-26

• basically a reorder point system, but the order quantity is incremented by the amount of the difference between the reorder point quantity and the quantity on hand + quantity on order  backorders.
• takes into account that demand does not decrement inventory levels evenly. Therefore, inventory levels may fall below the reorder point at the time that it is reached.
Add increment ROP
 q to order size
M
~
Q * Q
1
Q
2
ROP q
LT
Dickson Chiu 2006
LT Time
Inventory-27

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a combination of the min-max and the periodic review systems. stock levels are reviewed periodically, but control the release of the replenishment order by whether the reorder point is reached. useful where demand is low, such that small quantities might be released under a periodic review method.
T,R,M variant
Q
1
Inventory not below
R , so don’t place an order
Q
2
R q
LT
R = reorder point
T = review time
T
LT
Time
Dickson Chiu 2006
T
M
– Q
= replenishment quantity
Inventory-28

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This is an important periodic review method, not so much because of its accuracy but because of its popularity in practice.
The method is synchronized with the period of the forecast. The target quantity ( follows.
MAX ) is developed as
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Set the period of the forecast, say 4 weeks
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Add time for lead time, say 1 week
Add an increment of time for safety stock, say 1 week
Dickson Chiu 2006 Inventory-29

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The theory that has been discussed previously is useful when designing inventory control systems for the practical problem of controlling many items at many locations.
Consider how a specialty chemical company designed such a practical system.
TASO is the time to accumulate a stock order (truckload) for all items in warehouse.
M
Q
3
Q
1
Q
2
Stock order
0
TASO
LT
TASO
M = maximum level
TASO = time to accumulate stock order
Order received
Dickson Chiu 2006
LT
TASO
Time
Q i
= order quantity
LT = lead time
Inventory-30

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The service level (stock availability) actually achieved by inventory control methods is by the probability ( not best represented
P ) of a stockout during the lead time.
This actual level is higher that was used to set the inventory level.
The reason is that there are periods of time when the stock level is above the reorder point and there is no risk of being out of stock.
Methods for defining stock availability include:
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Probability of filling all item demand
Probability of filling an order completely
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Probability of filling a percent of all item demand
Weighted average of items filled on an order (fill rate)
Dickson Chiu 2006 Inventory-31

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Control the entire channel inventory levels, not just a single echelon.
How much stock here when retailers also carry stock?
Warehouse echelon
S
Warehouse lead-time, LT w
W
Ret ail l ead
LT R
tim e,
R
1
R
2 d , s
1 d
1 d
2
, s d
2
Supplier Warehouse
R
3 d , s
3 d
3
Retailer
Dickson Chiu 2006 Inventory-32

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Product items can be grouped according to 80-20 curve, each with different stocking policies
100
90
80
70
60
50
40
30
20
10
0
0
A items B items
20 40 60
Total items (%)
C
Dickson Chiu 2006 items
80 100
Inventory-33

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There is a
in the average inventory level of an item as the number of stocking points in the supply channel is
.
Both regular stock and safety stock decline.
Dickson Chiu 2006 Inventory-34

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Stockouts are filled from other stocking locations in the distribution network
Customers assigned to a primary stocking location
Backup locations are usually determined by
“zoning” rules
Expectation is that lower system-wide inventories can be achieved while maintaining or improving stock availability levels
Total distribution costs should be lower to support the cross filling of customer demand
Dickson Chiu 2006 Inventory-35

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Suppose that an item is stocked at a fill rate of 80% in
4 stocking locations. If cross filling is used, what is the effective fill rate for the customer?
Fill rate = [1 – (.20)(.20)(.20)(.20)] x 100 = 99.8%
Customer service levels can be quite high even if the item fill rate is low!
location A location B
Dickson Chiu 2006 Inventory-36

FR =70%
Lower safety stocks from lower fill rates
FR =90%
0 5 15 25 35 45 55 65 75 85 95 100
Dickson Chiu 2006 Inventory-37


$ are at cost
Dickson Chiu 2006 Inventory-38

Business Logistics Management, 5/E (Chapter 10)
39

Forecast
Inventory
Build schedule
Orders
Bill of materials
Shortages
Purchase order releases
The point: Supply is to inventory or to requirements
Production release
To vendors
Dickson Chiu 2006 Inventory-40

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Just-in-time concept
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Material requirements planning (MRP)
KANBAN
Dickson Chiu 2006 Inventory-41

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A philosophy of scheduling where the entire supply channel is synchronized to respond, in as short a time as possible, to the requirements of operations
Close relationship with a few suppliers and transport carriers
Information is shared between buyers and suppliers
Frequent production/purchase and transport of goods in small quantities
Minimum inventory levels
Uncertainties are to be eliminated wherever possible throughout the supply channel
Dickson Chiu 2006 Inventory-42

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A formal, mechanical method of scheduling whereby the timing of purchases or supplies is determined by offsetting the requirements in the master production schedule.
Why requirements become lumpy for the materials manager
Setting the master schedule
 through derived demand patterns and bill of materials explosion
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 forecasting orders on hand
Dickson Chiu 2006 Inventory-43

( a ) Field inventory (Finished product in warehouse)
Order point
0
Order placement
( b ) Factory inventory (Finished product at plant)
Time
Order point
Production order release
0
( c ) Component inventory (Supply stocks at plant) Time
Order point
0
Purchase order release
Dickson Chiu 2006
Time
Inventory-44

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The mechanics of lot-for-lot scheduling given certain requirements and lead times
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Purchase orders are matched on a one-for-one basis with requirements.
Determining lot sizes
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Trading purchase price for inventory carrying cost
Vendors can set order minimum quantities to avoid the high cost of handling small orders.
This will usually force some inventory into the system.
The economically best order quantities can be set by balancing the cost of processing an order with the cost of carrying the inventory associated with ordering more than what is immediately needed.
Handling uncertainties in the master schedule
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Minimum inventory levels
Part-period cost balancing
Handling lead time uncertainties
Dickson Chiu 2006 Inventory-45

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Toyota’s method of scheduling using the order point inventory control procedure, but with very low setup costs and very short leadtimes
Models are repeated frequently in the master schedule.
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A typical master schedule for economies of scale might look like
AAAAAABBBBBBAAAAAABBBBBB but a KANBAN schedule would approach
ABABABABABABABABABABABAB
Lead-times are predictable because they are short and because suppliers are located near the site of operations
Order quantities are small because setup or procurement costs are kept low
Few vendors are used with high expectations of vendors and high level of cooperation with them
Classic reorder point inventory control is used to determine reorder quantities and timing of purchases
Dickson Chiu 2006 Inventory-46

Factors KANBAN/JIT scheduling
Set Ups Make them insignificant. This requires either extremely rapid changeover to minimize the impact on operations, or the availability of extra machines already set up. Fast changeover permits small lot sizes to be practical, and allows a wide variety of parts to be made frequently.
Queues Eliminate them. When problems occur, identify the causes and correct them. The correction process is aided when queues are small. If the queues are small, it surfaces the need to identify and fix the cause.
Supply to Inventory
Low priority. Maximum output is the usual goal. Rarely does similar thought and effort go into achieving quick changeover.
Necessary investment. Queues permit succeeding operations to continue in the event of a problem with the feeding operation. Also, by providing a selection of jobs, the factory management has a greater opportunity to match up varying operator skills and machine capabilities, combine setups and thus contribute to the efficiency of
Inventory-47

Factors
Vendors
Quality
Equipment mainten-
KANBAN/JIT Scheduling
Co-workers. They're part of the team.
Multiple deliveries for all active items are expected daily. The vendor takes care of the needs of the customer, and the customer treats the vendor as an extension of his factory.
Zero defects. If quality is not 100%, production is in jeopardy.
Constant and effective. Machine breakdowns must be minimal.
ance
Lead times Keep them short. This simplifies the job of marketing, purchasing, and manufacturing as it reduces the need
Supply to Inventory
Adversaries. Multiple sources are the rule, and it's typical to play them against each other.
Tolerate some scrap. Scrap is tracked and formulas are developed for predicting it.
As required. But not critical because of queues available.
The longer the better. Most foremen and purchasing agents want more lead time, not less.
Dickson Chiu 2006 Inventory-48

Factors
Workers
KANBAN/JIT Scheduling
Management by consensus. Changes are not made until consensus is reached, whether or not a bit of arm twisting is involved. The vital ingredient of "ownership" is achieved.
Supply to Inventory
Management by edict. New systems are installed in spite of the workers. The concentration is on measurements to determine whether or not they're doing it.
Dickson Chiu 2006 Inventory-49

Supply channel
Customer Customer
Firm A Firm C
Firm B
Firm A
Firm C
Demand on upstream firms varies greatly with small changes in downstream demand
Dickson Chiu 2006
Time
Inventory-50

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Internal reasons for the effect
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Demand shifts
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Product/service changes
Late deliveries
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Incomplete shipments
External reasons for the effect
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Supply shortages
Engineering changes
New product/service introductions
Product/service promotions
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Information errors
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Dickson Chiu 2006
Remedies
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Centralize demand forecasting
Improve forecasting accuracy
Reduce lead-time uncertainties throughout the channel
Smooth response to change
Inventory-51

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The supplier usually owns the inventory at the customer’s location
The supplier manages the inventory by any means appropriate and plans shipment sizes and delivery frequency
The buyer provides point of sale information to the supplier
The buyer pays for the merchandise at the time of sale
The buyer dictates the level of stock availability required
Dickson Chiu 2006 Inventory-52

Business Logistics Management, 5/E (Chapter 10)
53

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Primarily a buying activity
A decision area to be integrated with overall materials management and logistics
At times, an area to be used to the firm’s strategic advantage
Mission: Securing the products, raw materials, and services needed by production, distribution, and service organizations at the the right place quantity .
, the right time right quality
, the
, and in the right price right
,
Importance
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Decisions impact on 40 to 60% of sales dollar
Decisions are highly leveraged
Dickson Chiu 2006 Inventory-54

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Price
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Cost of goods
Terms of sale
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Discounts
Quality
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Meeting specifications
Conformance to quality standards
Service
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On-time and damage-free delivery, order-filling accuracy, product availability
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Product support
Dickson Chiu 2006 Inventory-55

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Selects and qualifies suppliers
Rates supplier performance
Negotiates contracts
Compares price, quality, and service
Sources goods
Times purchases
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Sets terms of sale
Evaluates the value received
Measures inbound quality if not a responsibility of quality control
Predicts price, service, and sometimes demand changes
Specifies form in which goods are to be received
Dickson Chiu 2006 Inventory-56

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Past or anticipated relations
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Honesty
Financial viability
Reciprocity
Measured performance
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Price
Responsiveness to change or requests
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On-time delivery
Product or service backup
Meeting quality goals
Weighted average of ratings
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Operational compatibility
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Informational compatibility
Physical compatibility
Ethical and moral issues
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Minority vendors
Lowest price bidding
Patriotic purchasing
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Open bidding but a preselected vendor
Dickson Chiu 2006 Inventory-57

Single vendors
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Allows for economies of scale
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Consistent with the justin-time philosophy
Builds loyalty and trust
May be only source for unique product or service
Multiple vendors
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Encourages price competition
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Diffuses risk
May disturb supplier relations, reduce loyalty, reduce responsiveness, and cause variations in product quality and service
Dickson Chiu 2006 Inventory-58

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Personal contacts
Trade publications
Web sites, catalogs, and directories
Advertisements and solicitations
…
Dickson Chiu 2006 Inventory-59

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Previous experiences and formal rating schemes
Word of mouth
Samples of product
Reputation
Site visits and demonstrations
Dickson Chiu 2006 Inventory-60

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Company policy considering risk, fairness, ethics, etc.
Definitive methods
Is buying based on lowest price a good strategy – consider other costs too…
Allocate using linear programming
Asking “what if” questions can provide insight into good allocation plans
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 weak supplier - perhaps some price concessions can be negotiated valuable supplier and more capacity should be sought
Dickson Chiu 2006 Inventory-61

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Through just-in-time planning
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Material requirements planning for continuous work
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Gantt charts and CPM/PERT for project work
Through inventory management
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Push methods
Pull methods
According to market conditions
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Speculative buying
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Forward buying
Hand-to-mouth buying, or buying to current requirements
Dickson Chiu 2006 Inventory-62

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Buying more than the foreseeable requirements at current prices in the hope of reselling later at higher prices.
Some of the purchased quantities may be used in production and some simply resold.
Generally a financial activity, not a materials management one.
Dickson Chiu 2006 Inventory-63

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Buying to satisfy immediate needs such as those generated through MRP.
Advantageous when prices are
May improve cash flow by temporarily reducing expenses of carrying inventory
Dickson Chiu 2006 Inventory-64

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Buying in quantities exceeding current requirements, but not beyond foreseeable needs.
Takes advantage of favorable prices in an unstable market, or takes advantage of volume transportation rates
Reduces risk of inadequate delivery
Dollar Averaging
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Spend the same amount on each purchase with the idea of buying more when prices are low and less when they are high.
This is a good strategy when prices are expected to rise over the long term and there is substantial uncertainty as to the actual price level.
Because under-supply may occur, some level of inventory will need to be maintained.
Dickson Chiu 2006 Inventory-65

Quantity, Q
Price break curves
P i i
Price,
0 < Q i
Q i

Q
< Q
1
P
1
1
P
Curve for Q<500
Total cost
$
Feasible curve
Curve for Q

500
Q
2
Q
1
Dickson Chiu 2006
500
Order quantity, Q
Inventory-66

0
Price break curve: non-inclusive discounts
Cost for
0

Q i

Q
1
Price discount only applies to the items beyond the price break quantity.
Q
1
Purchase quantity, Q i
Dickson Chiu 2006
Cost for
Q i

Q
1
Inventory-67

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A one-time buying opportunity.
Determining the quantity to purchase requires balancing the benefits of a price discount against extra inventory holding costs.
Dickson Chiu 2006 Inventory-68

69

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Inventories is a major use of capital in the supply channel.
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Key tradeoff: lead time, demand, service, cost
Key difficulties: demand uncertainty together with lead time
Push vs pull
Purchasing and scheduling involve decisions that affect the efficient movement and storage of goods.
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Just-in-time scheduling procedures become popular
Toyota’s KANBAN and MRP scheduling
Combining Distribution and Materials Requirements Planning
(DRP and MRP) allows integration of the supply chain from suppliers to customers.
Purchasing is important, accounting for 40-60% of dollar sales typically.
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Impact on the efficiency of logistical activities
Key purchasing decision: quantities, timing, and sourcing
Dickson Chiu 2006 Inventory-70

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Again much domain knowledge is required.
Note the data / information requirements and how IT helps to collect / integrate the data for calculations and decision making.
Capture forecasting and ordering signals (either determined by a business analyst or automatically by a sub-system) as events / exceptions / alerts and forward them to the appropriate system and personnel for decision
/ action.
Effective collaboration with retailers and suppliers requires much new IT in the process and information integration, as well as relying on integrating with existing enterprise systems (e.g., MRP / DRP).
Note the difficulties in integrating with multiple suppliers, especially dynamic ones.
Dickson Chiu 2006 Inventory-71